'Cracks are emerging' in one of the riskiest parts of the market

The high yield credit market may be about to relive an unsavoury episode last witnessed in 2014. 

Cheaper commodities are lowering the prices of high yield bonds, indicating that investors are demanding fewer of them. High yield bonds are issued by companies with a greater risk of defaulting on their debt, and so investors demand a premium to lend them money.

These rising yields are widening the gap between high yield and comparable bonds. 

“Cracks are emerging in the high yield credit space that have the potential to blow out spreads in similar fashion to what occurred in 2014,” Pavilion Global Markets said in a note on Friday.

“At that time, high yield credit spreads blew out as metal and oil prices fell sharply. This reversed violently in early 2016, when Chinese stimulus spurred commodity demand, which in turn lifted prices. Now, Chinese stimulus is fading and commodity prices are falling — a situation high yield debtors are ill-equipped to face, and that is exacerbated by rising interest rates.”

Pavilion noted that metals and energy were major culprits of the spike in spreads that started three years ago. And right now, US shale-oil producers are vulnerable to lower prices because the market remains oversupplied. 

West Texas Intermediate crude oil, the US benchmark, fell this week to its lowest level since last November after it slipped below its 200-day moving average — a technical signal of a reversal in the trend. Other commodities including silver and copper have also tumbled this week. 

There are nascent signs that high-yield investors could be headed for the hills. According to Bloomberg, the iShares high yield exchange-traded fund on Thursday had its biggest outflow since October. 

Flows to high grade bond funds, which track companies with a lower risk of default, are outpacing flows to high yield funds so far this year, according to Bank of America Merrill Lynch. 

“Large high grade inflows are back,” said Yuriy Shchuchinov in a note on Friday. 

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